To better understand what “intrinsic value” is for a stock, let’s first look at the stock’s price-earnings ratio , sometimes referred to as the PER, the P/E ratio or just the P/E.
The price (P) in the numerator refers to the price of the stock. The earnings (E) in the denominator refers to the earnings per share (EPS) of the company.
Let’s use some figures to illustrate the P/E ratio. Assume a company XYZ made a full-year net profit of $10 million and the company has in issue 100 million ordinary shares. The earnings per share (EPS) for the full year would then be $0.10. This is derived from dividing $10 million by 100 million.
If XYZ shares are now trading at $2 each, the price-earnings ratio for this stock is then 20. This is derived from dividing $2 by $0.10.
This means the stock market has valued the stock at 20 times its earnings. Is the stock at a P/E ratio of 20 considered expensive or cheap? We can compare the P/E ratio of XYZ with those of its industry peers. Or we can compare its ratio with the industry’s average. And from the comparisions, we have a relative measure of XYZ’s worth against its peers or the industry in which it is in.
But a P/E ratio of 20 alone cannot tell us if the stock of XYZ is overvalued or undervalued. To be able to judge the valuation, we need this concept known as “intrinsic value”, which measures what a stock is worth.
So what is a stock worth in terms of intrinsic value?
Let me quote Morningstar’s Pat Dorsey, author of “The Five Rules For Successful Stock Investing”. He said in the 2004 book: “Luckily, we can stand on the shoulders of giants such as economists Irving Fisher and John Burr Williams, who answered this question for us more than 60 years ago: The value of a stock is equal to the present value of its future cash flows. No more and no less.”
We can define the intrinsic value of a stock as the value of the stock determined through fundamental analysis without reference to the market value (the stock price). Some call the intrinsic value the fundamental value. It is ordinarily calculated by summing the discounted future income generated by the company to obtain the present value. This is a simple discounted cash flow (DCF) model.
As explained in Pat Dorsey’s book, companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some gets reinvested in the business and the rest is “free cash flow”.
“The free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today,” says Pat Dorsey.
Why are future cash flows worth less than current ones?
First, money that we receive today can be invested to generate some kind of return, whereas we can’t invest future cash flows until we receive them. This is the time value of money, explains Pat Dorsey.
Second, there’s a chance we may never receive those future cash flows, and we need to be compensated for that risk, called the “risk premium.”
Remember this post said earlier that the intrinsic value is ordinarily calculated by summing the discounted future income generated by the company to obtain the present value. It’s a discounted cash flow (DCF) model.
What this means is that we need a “discount rate”.
The time value of money is often represented by the interest being paid on government bonds. The certainty of payment makes this the risk-free element.
But cash flows of a company are not as certain. So we need to add a risk premium to compensate for the uncertainty.
The discount rate is actually the sum of the government bond rate and the risk premium. This is the rate that is used to work the future free cash flows backwards to arrive at the present value or intrinsic value of a stock.
Let’s say the intrinsic works out to $3. Remember we said earlier that the stock’s market value was $2. This means, from the intrinsic value point of view, that the stock is undervalued. If on the other hand the intrinsic value is $1, it means the $2 stock is overvalued.
Examples of intrinsic value calculations will be the subject of another post.